Is Your Fixed Income Investment Risk-free?

Equities, as we all know, are subject to market risk. But is your fixed-income investment risk-free? The answer is no. Debt funds, for instance, are subject to interest rate risk and credit risk.

JP Morgan Asset Management Company's recent move to cap redemptions from its two funds reveals the risks even investors in debt funds face. These two funds are JP Morgan India Treasury Fund (assets under management, AUM, of Rs2,311 crore) and JP Morgan India Short Term Income Fund (AUM Rs 450 crore).

The redemption cap is one per cent of units outstanding in each scheme, on a first-come-first-served basis. Units that don't get redeemed on the day the application is filed will be considered on the next business day, subject to the approval of the mutual fund and its trustees. This includes all switches, systematic withdrawals and systematic transfers. The Short Term Income Fund's net asset value (NAV), is down 3.25 per cent, while the Treasury Fund's NAV has fallen two per cent, since this move.

SO WHAT WENT WRONG?

The funds had a big exposure to the corporate paper of Amtek Auto Ltd, which has seen a rating downgrade. While JP Morgan Short Term Income Fund has an exposure of 11 per cent to Amtek Auto Money Market Bonds, the figure for the other fund is six per cent. The crisis was triggered after CARE Ratings, on August 7, suspended the rating assigned to the bank facilities (worth Rs7,640 crore, plus Rs2,000 crore NCDs) of Amtek Auto as the company had not furnished the information needed to monitor the ratings.

On May 27, CARE had revised the ratings from AA to AAdue to drop in sales and profitability in the second quarter of 2014/15, and risks related to recent acquisitions by the company. Signs of a drag were visible even then. On August 27, Brickwork Ratings also downgraded the rating on Amtek's secured redeemable NCDs to C from A+, citing financial problems with the company.

Since many corporate papers, like that of Amtek Auto, are not traded daily in the market, fund houses use valuations released by ratings majors Crisil and ICRA. A downgrade of a corporate paper leads to lowering of its valuations and, hence, the NAV of the fund holding it.

The fund has also proposed segregation of assets held by the schemes. One set will comprise a single security that is no longer investment grade and is currently illiquid. The second will be other assets of the respective schemes. This is yet to come into effect.

RISK VS RETURNS

Srikanth Meenakshi, founder and COO, FundsIndia.com, says investors should exit the funds whenever they get the chance. Fund managers invest in corporate papers for higher yields and returns. Amtek Auto's bonds, for instance, could have provided 40-50 basis points(bps) over other papers, he adds.

Although asset management companies (AMCs) state in their key information memorandum that they have the right to limit redemptions in certain cases, Gaurav Mashruwala, Certified Financial Planner, does not advocate such a move. "AMCs have many other ways of raising money and hence should not hold investors' money," he says.

According to Anil Chopra, Group CEO & Director, Bajaj Capital, debt funds do not assure protection of either capital or returns. "So, if there is a default on the underlying investment, the NAV will be hit, and investor returns or capital may be eroded to that extent," he says. One must remember that mutual fund investments are subject to market risk. However, at times, reputed AMCs or their sponsors take the hit of such writedowns on their own books instead of passing it on to investors. In such cases, investors are protected to an extent.

WATCH OUT

The key lesson from the above episode is that investors must be careful with their fixed income investments. Corporate fixed deposits (CDs), for instance, become popular when interest rates are falling as they offer a higher rate. According to Mashruwala, investors must refrain from these due to the risk involved. "A large number of these companies approach small investors as banks and other lenders are reluctant to lend them money," he says.

Unless there is a huge difference in returns between the CD on offer and other fixed income instruments, one can avoid the former. One can look at the recent defaults to understand this.

According to Chopra of Bajaj Capital, while choosing a corporate deposit, investors should look at the track record of the company as well as its ratings and reputation. "In any case, not more than fi ve per cent funds should be invested in one company," he says.

"Avoid investing in companies with high leverage," says Murthy Nagarajan, Head, Fixed Income, Quantum AMC. Any company with debt higher than four times equity should be avoided, he adds. Track the company's profit margin before interest and tax, as this will indicate its ability to repay debt. Nagarajan advises investors to avoid the power sector as debt there can be as high as seven-eight equity as well as the real estate sector, where debt is five-six times equity. Unitech, for instance, defaulted on its deposit in 2011 due to high debt. For manufacturing companies, debt is usually two-three times equity.

Also, the share price of a company is a big indicator of trouble. The share price of Amtek Auto, for instance, was Rs280 three months ago; it is now around Rs50.

According to Nagarajan, investors must do due diligence before investing in a company as there is no recourse is anything goes wrong later. For the uninitiated, a credit rating may help him find out which is a safer investment. A rating represents the agency's opinion on likelihood of the debt obligation being honoured in full and on time. According to Nagarajan, investors should not buy anything with below AA rating. One must also learn the basics of what these ratings mean. CRISIL, for instance, uses simple alphanumeric symbols.

WHERE TO INVEST NOW

Chopra says he does not recommend fixed deposits to investors at this stage. Bank deposits offer low yields (more so after the recent rate cuts by banks) and are tax-inefficient. Corporate deposits carry default risk if they are poorly rated. If rated higher, the coupon rate is low. "Moreover, investors do not benefit from any fall in interest rates," he says. Also, corporate deposits have liquidity issues as investors have to pay a hefty penal interest in case of premature withdrawal and that too at the discretion of the company.

Mutual funds are an ideal investment for fixed income investors at this stage. One should not get disenchanted with the entire category due to a single incident at one or two funds. AMCs typically do rigorous credit risk evaluation. They are also tightly regulated by the Securities and Exchange Board of India and, hence, their safety quotient is high.

"With interest rates expected to come down in the near future, one can invest in long duration funds, which are more sensitive to changes in interest rates," says Rahul Goswami, CIO Debt, ICICI Prudential AMC. Interest rates and bond prices share an inverse relation; a fall in rates increases bond prices and, thus, the NAVs of funds holding these bonds.

The longer the duration of the bonds, the better returns the fund will give. However, these are also volatile and suited for those with an investment horizon of more than three years. For less than six months, investors can look at liquid ultra short term debt funds.

For six months to one year, short term debt funds are ideal. From a one- to three-year perspective, one can invest in short-term debt funds and accrual funds, which mainly focus on earning coupon payments and are not so affected by interest rate movements. Hence, they are less volatile.

CHOOSE WISELY

"Consistency in returns, both absolute and risk adjusted, and performance versus the benchmark and the peer set is something investors may look at while selecting a debt fund," says Chopra of Bajaj Capital. Another important thing is the credit quality of the portfolio. "Investors must see the underlying portfolio and what papers is the fund is holding," says Nagarajan of Quantum AMC.

The more a fund has invested in papers rated AA and above, the better it is. Apart from these, one should also look at the expense ratio of the fund as it has a bearing on returns. Also, one should see whether the fund has a track record of sticking to its mandate or not